Regulation

Another potentially explosive aspect of the 2,200-page Lehman report (as well as the likely wave of lawsuits against those named as having “colorable causes of action” against them) is the claim that the regulators knew about the problem, but failed to act. Consider the action of the Federal Reserve Bank of New York after Bear Stearns collapsed in 2008: (report page 1488)

The FRBNY [New York Fed] developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.” Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed. It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

Here we go again. Germany, France, Spain, Greece and Portugal are talking about extra regulations on credit default swaps, the insurance-like derivatives that let investors bet on debt problems, accusing the international media of a conspiracy or shouting about “speculators”. Some of the more excitable reports even suggest governments have called in the secret services to keep an eye on the hedge funds, although in typical German fashion Berlin called in its financial regulator, instead.

New regulations are already being mooted, with Jean-Claude Juncker, who chairs the eurozone finance ministers, warning of “torture equipment” ready to be used against speculators. But we’ve been here before. At the height of the banking crisis, short-selling bank equity (and in the US much other equity too) was banned, as short-sellers were blamed for the problem – including by John Mack (head of Morgan Stanley, then the biggest servicer of hedge funds wanting to short) and the Archbishops of York and Canterbury (the Church of England invested in hedge funds).

It is true that aggressive, co-ordinated short selling could create a problem at a bank by damaging confidence, starting a run on its short-term funding. But that could only create a liquidity problem. It turns out, of course, that the short-sellers were shorting precisely because there was already a confidence problem caused by the (correct) belief that the banks had a solvency problem. If there was any co-ordinated shorting – which remains unproven, but is being investigated – that was not the problem.

In Greece, the same argument applies. Is a loss of confidence causing the problem, or is the Greek economy like souvlaki – totally skewered?

A loss of confidence is much harder in a country than a bank: you can’t have a run. But theoretically the price of raising sovereign debt, and so commercial debt, could be pushed up, costing the country more. This is happening – but it isn’t happening because of the “shorting” effect of hedge funds buying CDS protection.

Quite the opposite. Hedge funds are – or at least were – buying CDS protection years before the problems emerged, because they believed the market had too much confidence in Greek debt. Greece is a serial defaulter, had a credit-fuelled bubble created by importing German interest rates, and saved far too little.

On top of that, Adair Turner, chairman of Britain’s Financial Services Authority, on Tuesday pointed out that short selling was not the big deal it is being made out to be. He is no fan of CDS – he has warned several times that some financial instruments are “not socially useful” – but he is also pragmatic, having been happy with the short selling ban on banks.

It is important that even if we look at this issue we don’t overstate it. A fundamental issue that can drive volatility on spreads on Greek bonds is a whole load of long investors not being willing to buy.

I believe the total amount of CDS short positions in the area of Greek problem debt is only 3-4 per cent of outstanding Greek sovereign debt. The biggest driver is confidence levels and actions of long investors.

In other words, pension funds and other “good” investors are shy of buying Greek debt, not surprisingly. So not only is it not bad that hedge funds were shorting Greek debt, they weren’t even driving down its price by doing so. The current bail-out talk is already creating the risk of a short squeeze, bringing in spreads, as the WSJ points out.

None of this is likely to stop eurozone finance ministers blaming nasty foreign Anglo-Saxon casino capitalists for their troubles; some hedge funds closed out their short positions on troubled countries weeks ago because they feared exactly this political intervention (although they are now shorting the euro as a whole instead).

However, there is a genuine debate to be had about whether the use of CDS to take speculative positions, rather than simply to hedge existing positions, should be banned. Taking out insurance on something you do not own (which is akin to a “naked” CDS trade) is banned precisely because it creates the incentive to do what you can to damage the thing insured – in this case Greek debt. Plenty of people have argued CDS should be treated on a par with other forms of insurance, famously including Warren Buffett and most recently James Rickards, the former LTCM general counsel, and FT columnist Wolfgang Münchau.

I tend to the view that the incentive is different to fire insurance, and best controlled through regulation; owners of shares, after all, have an incentive to drive up the price through foul means, which we are quite happy to see controlled through regulation. But perhaps the CDS market cannot be made transparent enough, and liquid enough, to prevent it being used for large-scale manipulation, in which case it should be restricted.

In Greece, though, it does not appear to be manipulation by hedge funds which is causing the wide bond spreads. So finance ministers should address their problems at home, before trying once again to turn speculators into scapegoats.

The New York Times has published 18 ways to break up the banks with minimal fuss, and I can’t find a single flaw in their reasoning. My personal favourites are “Have the bank marry Larry King or Elizabeth Taylor” and “Have the bank’s chairman saunter into the living room at 11:02 p.m. and start idly vacuuming”.

At the height of the crisis, in November 2008, the Queen asked a room of academics at the London School of Economics what could be the key question of the last few years: “Why did nobody see this coming?”

It is a question seized on by David Hare in his new play, The Power of Yes, but which is arguably better answered by Lucy Prebble (a Londoner in her 20s) in her play Enron, which debuted in London’s West End last night, and which ostensibly has nothing to do with the credit crisis and its aftermath.

Enron‘s West End debut, especially for those who, like me, were seeing the play for the first time, was a triumph. The acting was compelling and believable, especially from Sam West, who as Jeff Skilling managed to make a seamless transition from maths nerd to master of the universe. This was coupled with the kind of spectacular pyrotechnics that audiences expect from a Rupert Goold production, including a stunning representation of 9/11 (an event not exactly easy to re-create within the confines of a West End stage). Nor were the special effects out of place: Prebble explained recently in the FT that part of the point of the elaborate staging was to capture something of the out-of-control nature of Enron itself.

But the real star was the writing. Some of it seemed too prescient to have been written before the current crisis, and Prebble says in the FT piece that she re-wrote parts for the West End. But in one scene, which must have been there from the play’s inception, she captures perfectly how Enron got into the position it did and why no one saw it coming, and it is a scene that translates perfectly for the current crisis.

Barack Obama has decided to side with a state solution, if not yet a well-thought-out one, to preventing bank failures bringing down the world economy. But there is a market alternative: fix the banks so the bondholders keep bank risk-taking under control – and bear the costs if they fail in that task.

This important debate is not being framed as a state vs market discussion, but it should be. Remember state control has a dismal record in general, and in the finance sector in particular. Regulators entirely missed the bubble, missed the banks’ reliance on short-term financing and missed the fact that so much regulatory arbitrage was going on. Don’t expect things to be much different in 20 years if a state solution is accepted.

The problem is the banks (and potentially non-banks) being too big to fail, creating perverse incentives to take risks and leaving the taxpayer paying for mistakes. The state solution accepts banks are too big, but tries to control that through regulations, restrictions on what they can do (no prop trading or hedge funds), and potentially a cap on size.

A working market solution would obviously be better, as it would be pretty much immune to the high likelihood of regulatory capture – but can a market solution be made to work? I think so.